Revenue-Weighted ETFs: A New Twist On an Old Drink

As ETFs have become the investment vehicle of choice for an increasing number of asset managers and individual investors, the landscape continues to evolve, sometimes seemingly on a daily basis. The first ETFs to burst onto the scene generally tracked traditional asset classes and indexes. And while these “plain vanilla” funds remain among the most popular investor choices today (State Street‘s SPY, which tracks the S&P 500, is acknowledged as the first U.S. ETF, and today remains the largest and most actively-traded ETF), numerous funds tracking non-traditional assets and indexes have sprung up in recent years, expanding the reach of ETFs to nearly every corner of the investment sphere.

Worth the Weight?

The vast majority of ETFs on the market today track indexes constructed using traditional market capitalization-weighting methodologies. While market capitalization-weighted indexes have many advantages and are widely accepted and understood by investors, there are some drawbacks that have opened the door for several ETF sponsors promoting alternative weighting methodologies. Perhaps the most frequently cited downside is the fact that market capitalization-weighted indexes are bound to overweight overvalued companies (those with a market capitalization greater than their intrinsic fair value) and underweight undervalued companies. The consequences of doing can be detrimental to returns if prices revert to their fair value over the long term.

Alternative Methodologies

WisdomTree is regarded as a pioneer in the area of alternative weighting methodologies, introducing several “fundamentally-weighted” ETFs that determine their holdings based on factors such as earnings or dividends. In making the case for weighting funds by these metrics, WisdomTree notes that dividends are an objective measure of value and profitability that cannot be manipulated, while weighting by earnings can eliminate money-losing and speculative companies that often increase a portfolio’s volatility.

Rydex has also put a unique spin on the art of index weighting, introducing a line of equal-weighted ETFs. These funds hold all constituents of well-known equity indexes (such as the S&P 500 and various sector-specific benchmarks) but apply an equal weight to each stock held. For example, the Rydex S&P Equal Weight ETF (RSP) holds 500 common stocks (all components of the S&P 500), each with an original weight of 0.20%. As prices of these securities rise and fall, weightings will inevitably move away from this equal level, presenting the need for occasional rebalancing.

“The Top Line is the Bottom Line”

Revenue-weighted ETFs are based on well-known and widely followed indexes, such as the S&P 500 and S&P MidCap 400, but feature a little twist when determining the weightings of the fund components. Instead of using market capitalization or fundamental factors such as earnings or dividends, relative proportions of holdings are based on top line revenue. “We believe that a revenue-weighted index will produce higher returns than a cap-weighted index over time with the same holdings and a slightly lower beta,” says RevenueShares President Sean O’Hara, whose firm pioneered revenue-weighted ETFs. Indexes utilizing a revenue-weighted methodology, while yet to find widespread popularity, hold several advantaged over both traditional market-capitalization weightings and fundamental-weighting strategies.

Buying High, Selling Low?

The most frequent criticism of market-capitalization weighted indexes is that such a methodology inherently overweights overvalued companies and underweights undervalued companies. Suppose a company has a fair value of $500 million, but due to the vagaries and short-term inefficiencies of equity markets, its market capitalization is currently $550. If included as a constituent of a market capitalization-weighted index, this theoretical company would receive more weight than it would if it were trading at its intrinsic value, resulting in an amplified loss of value if it returns to its fair value. Similarly, companies whose market capitalization is temporarily depressed will be underweighted, and investors will shortchanged on the price appreciation.

No Stock Left Behind

Since they are based on earnings or cash flow metrics, fundamental-weighted indexes aren’t subject to the same over/underweighting issues, but they have a few drawbacks of their own. Since the most popular “fundamentals” are earnings and dividends, these indexes may introduce a value bias and shrink the universe of potential constituents. First, since many stocks classified as “growth” equities have low or negative earnings, these companies would tend to be underweighted, or even excluded, from earnings-weighted indexes. Second, growth companies tend to reinvest any cash flows, whereas value companies are generally more inclined to pay them out as dividends. So in an index that determines weightings based on dividends may also be bent towards value stocks. This isn’t necessarily a bad thing, as long as investors are aware of the tendencies their portfolios may have if utilizing these weighting methodologies. Weighting holdings by top line revenue, on the other hand, may result more balanced holdings.

Rewarding the Crooks?

As many investors have learned the hard way, earnings are subject to manipulation. We saw a wave of accounting scandals earlier this decade (Enron and WorldCom jump to mind immediately, but the list goes on and on), and although improved regulations (SoX) seem to have been effective, it’s unlikely we’ve seen the last of CFOs cooking the books. An unintended consequence of earnings-weighted indexes is overweighting companies engaging in fraud and financial mismanagement. Since EPS is the most scrutinized earnings measure on Wall Street, earnings are more likely to be manipulated than is revenue (although falsifying revenue numbers isn’t unheard of either). The toughest metric to manipulate is of course dividends, since investors are likely to notice if the declared cash payments don’t end up in their pockets.

Opportunistic Indexes

While revenue-weighted indexes are appealing for their solutions to drawbacks plaguing other weighting methodologies, there is also some evidence to suggest that they outperform their market capitalization-weighted counterparts in certain economic environments. Many investors utilize various pricing ratios to determine whether the stock market as a whole is overvalued or undervalued. While price/earnings is the most popular ratio, price/ revenue may also be a powerful valuation metric. Relatively high price/revenue ratios would indicate the market is overvalued, while low ratios would indicate it is undervalued. Over the last 30 years, the average price/revenue multiple for the S&P 500 has been approximately 1.1. During this period, the S&P 500 has performed significantly better when the market’s price/revenue ratio was below 1.0 in the previous year.

Price/Rev. (Previous Year)

S&P 500 Avg. Annual Return

Number of Years

Less Than 1.0

16.73%

17

Greater Than 1.0

7.05%

13

Moreover, four of the five best annual returns on the S&P 500 over the last 30 years have come following a year when the price/revenue ratio for the market fell below 0.95 in the previous year.

While equity markets are efficient in the long term, the same can’t always be said for the short term. Revenue-weighted ETFs seek to capitalize on short-term imbalances when price/revenue ratios exceed a fair level. By rebalancing annually, these funds effectively shift their holdings from high price/revenue stocks to low price/revenue stocks, positioning them to outperform traditional indexes if price/revenue ratios revert to their historical mean. During 2008, the S&P 500 traded at 0.88x revenue, indicating an upward correction to this ratio may be coming.

So far, investors who picked up on this trend at the beginning of the year have been handsomely rewarded. To date in 2009, the revenue-weighted ETFs offered by RevenueShares have significantly outperformed traditional iShares ETFs tracking similar indexes, but implementing a market capitalization weighting methodology.

While revenue and market capitalization tend to share a fairly strong correlation among large cap stocks, this relationship weakens as the equities decrease in size, resulting in significant difference among ETFs that seek to replicate the performance of indexes comprised of identical stocks, but applying different methodologies to determine the relative proportion of each. RevenueShares ETFs offer an intriguing investment play, providing exposure to widely-held, liquid securities but tweaking the weighting systems in an attempt to outperform well-known indexes.

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